Global Financial Systems Chapter 17 The ongoing crisis ... · Buildup Hidden risk Banking changed Crisis 2007–2008 Policy response Global Financial Systems Chapter 17 ... • Keynes

Global Financial Systems © 2019 Jon Danielsson, page 1 of 49

Buildup Hidden risk Banking changed Crisis 2007–2008 Policy response

Global Financial Systems

Chapter 17

The ongoing crisis 2007-2009 phase

Jon DanielssonLondon School of Economics

© 2019

Global Financial Systems: Stability and Riskhttp://www.globalfinancialsystems.org/

Published by Pearson 2013

Version 1.0, August 2013



Book and slides

• The tables and graphs arethe same as in the book

• See the book forreferences to original datasources

• Updated versions of theslides can be downloadedfrom the book web pagewww.globalfinancialsystems.org



Background



Historical contextthe first globalism

• First globalism until the Great War (1914)

• Crises in the first globalism had liquidity as a centralelement, e.g.

• summer of 1914• 1866 and LOLR• 1764

• During first globalism, liquidity became a central elementin policy response



Second globalismfrom end of Bretton Woods

• Global financial markets grew rapidly in prominencearound 1970

• The big battle for central banks was inflation (next slide)

• Central bank independence and primacy of monetarypolicy

• Similarly financial regulations focused on prudentialbehavior

• survival of the institution not the system



The fight against inflationsuccessful generals syndrome

• Keynes misunderstood — Philips curve — always printmoney to combat downturns

• Politicians’ dream

• Stagflation — stagnation and inflation

• Fighting inflation is a very painful process

• Monetarism, high interest rates, Saturday night massacre

• Today inflation targeting

• After that many (but not all) leading people in centralbanks thought the only thing central banks should do wasfighting inflation



The brave new worldemergence of second globalism

• Reaction to 1973 oil crisis was monetary expansion

• International capital markets start taking off after a longbreak

• Western banks recycle Middle Eastern petrodollars toLatin America

• From 1975–1982 its borrowings from abroad increasefrom $75 billion to $313 billion

Financial system becomes source of systemic risk



The new order

• IMF and World Bank insist on conditionality for lending— structural adjustment programs

• Substantial costs of structural adjustments

• Sets the stage for anti–globalism

• And the Washington consensus



Asia reacts to the 1997 crisis

• Reserves in dollars

• Exchange rates kept low to help exports

• Asia exports capital

• Helps to lower interest rates in the US and elsewhere

• China exports deflation to other countries



Monetary policy and bubblesmostly in the US but other countries follow

• Interest rates kept low

• And lowered when something bad happens• 1998• 9/11• etc.

Greenspan put

• Inflow from Asia helps

• Traditional investors in government securities lookedelsewhere



Savings glut?

• A lot of complaints about too much debt — but theflipside is assets

• Is there too much savings in the world relative toinvestment opportunities?

• Giving rise to global imbalances

• Controversial because data is limited on capital flowsinternationally

• Question is unsettled



Efficient markets

• Belief in “excessive” market efficiency to blame

“clear that among the causes of the recent financial crisis wasan unjustified faith in rational expectations [and] market

efficiencies.”Paul Volker

• As used by financial economists, means something muchmore narrow



What about crises?

• Happen in other countries• real estate bubbles• hot money inflows• inappropriate deregulation (S&L, Scandinavia)• prevented in our country by prudential regulations

• Nothing to do with the central bank

• CBs woefully ill–prepared

• Financial stability not a priority



Hidden and Ignored Risk



Crises are the same

• Financial crises usually have common elements

• Inflows of money

• Banks lend to increasingly marginal credits

• Asset price bubble

• Real estate, sovereigns, SMEs

• Valuations out the connections with the fundamentals

• Everything reverses at warp speed

Still, there are unique elements...



Financial innovation, models and complexity

• The root causes are the same as in a typical crisis

• But there are unique elements

• Changing nature of banking

• Complexity and models — financial innovation

• Procyclicality of regulations

• Short–term funding — maturity mismatches



Beginning of end (July 2007)

Subprime crisis




Subprime crisis

Capital reduced




Subprime crisis

Capital reduced

Volatility/riskincreases




Subprime crisis

Capital reduced


Difficult/impossible to roll overloans because margins/haircuts

increase




Subprime crisis

Capital reduced



increase

Fire sale




Subprime crisis

Capital reduced



increase

Fire sale firesaleexternality



Amplifiers

• Endogenous risk — losses feed them themselves —deleveraging

• losses• margins• capital

• Banking (within banks)• capital• precautionary hoarding• worries about borrowers — existing clients

• Confidence in banking (from outside)• bank runs• toxic assets

• Network effects — gridlock



Banks



In the “good old days”

Deposits

Household 1 Household 2

Bank

Loans

Firm Household 3

Credit risk

Maturity risk



The changing nature of bankingIn the “good old days” (up to the early 1990s)

• Banks collected deposits and made loans

• Their risk was• default risk• bank runs (liquidity risk)• maturity mismatch

• Network effects were present, but much weaker than now

• We still had regular banking crises• banks have this annoying habit of hubris, often real

estate or EMEs

• This is why banks are required to hold capital



Changing nature of banking

• Short-term financing (ABSM)

• Originate and distribute

• Structured credit products

• Complexity



Bank financing

Assets Liabilities

Long-term assets

Mortgages

Corporate loans

etc.

Capital (very expensive)

Long-term financing (expensive)

Short-term financing (cheap)

Three month commercial paper

Repo (one day)



Changing nature of banksbonuses dependent on profits

• Before the crisis financing was becoming ever shorter(was 40% overnight?)

• Banks start to rollover financing from one day to the next

• Create off-balance-sheet assets• structured products e.g. SIVs and Conduits (IKB)• creative accounting• hides liquidity risk (often from the bank itself)



Shadow banking

• Refers to institutions and banking practices that existoutside of the traditional regulated banking sector

• Move risk into entities under bank control, but not a partof the balance sheet

• Helps in tax and risk management, and aid in capitalstructure optimization (recall conduits)

• Enables banks to do business unseen by supervisors,shareholders, accountants in legal and compliant way

• Example of Goodhart’s Law

• Regulations create incentives to undermine regulations —shadow banks were one of the mechanism used.

• Many outlawed under Basel II



The Crisis 2007–2008



The canary in the coal mine diesRIP IKB July 2007

• Conduits e10 billion, (20% of IKB balance sheet)

• IKB 38% government–owned

• Bailout: e9 billion – until 2011 (e125 per German)



Surprises in July 2007

• Shares began to move in ways that were the opposite ofthose predicted by computer models

• Triggers selling by the funds as they attempted to covertheir losses and meet margin calls from banks

• Exacerbates the share price movements

• GEO had lost more than 30 per cent of its value

• Goldman’s flagship Global Alpha fund lost 27 per cent ofits value



Quant/hedge fund crisis

• High frequency — statistical arbitrage• quant models. Short–term reversal strategies

• Low-frequency• momentum strategy, etc.• carry trades

• Trades become crowded

• High dependence across strategies



The eye of the storm

• After the main crisis event in August 2007

• The worst seemed over

• But fundamental problems had been exposed

• Investors went on strike

• In the fall of 2007 and winter of 2008, more and morefinancial institutions started to face liquidity problems



Bear Stearns

• Weakest American investment bank started facing seriousdifficulties in early 2008

• In March 2008 NY Fed gave a $29 billion loan to J.P.Morgan to facilitate its takeover of Bear Stearns, buyingit at $10 a share

• Bear traded at $172 in January 2007, and $93 in February2008

“Given the exceptional pressures on the global economy andfinancial system, the damage caused by a default by BearStearns could have been severe and extremely difficult to

contain”Bernanke



Temporary calm

• Temporarily prevented widespread disruption in financialmarkets

• Was highly controversial and created the expectation thatthe authorities would similarly bail out other TBTF banks

• By September 2008, two important financial institutionswere facing difficulties, Lehman Brothers and AIG



Lehman Brothers

• Most disruptive event was the failure of Lehman Brotherson September 15, 2008

• An investment bank under then US rules

• Suffered large losses on real estate (classical way to fail)did not fail because of exotic instruments

• Turning point in the crisis

• Triggered a collapse in asset prices and an almostcomplete drying up of liquidity

• Government came under heavy pressure to bail Lehman’sout, but it did not do so, maintaining that there was nolegal authority for a bailout



Should Lehman’s have been bailed out?

• Against

1. expectations of any bank being bailed out2. encouraging risk taking and bigger future bailouts —

moral hazard3. failure forced everybody to recognize the seriousness of

the problem

• For

1. failure caused global liquidity to dry up2. setting world economy on the road to collapse3. creating uncertainty4. contributing to European sovereign debt crisis



AIG

• Day after Lehman’s, AIG bailout

• More systematically important since world’s largest writerof CDSs

• Fear that its default would trigger a systemic crisis

“It is hard for us, without being flippant, to even see ascenario within any kind of realm of reason that would see us

losing one dollar in any of those transactions.”Joseph J. Cassano, the AIG executive in charge of the CDS

unit, August 2007



• One of the world’s largest insurance companies

• Set up a London–based bank that quickly became theworld’s largest seller of CDSs helped by its AAA rating

• $450 billion of corporate CDSs, which suffered smalllosses, and about $75 billion of subprime–mortgage CDSswhich suffered more losses

• Caused AIG to be downgraded, increasing its fundingcosts and haircuts, in a typical vicious feedback loop

• Losses to tax payer still unknown but in low tens of $billion

• US taxpayer gave tens of billions of dollars tocounterparties, most to Goldman Sachs and DeutscheBank

• Collapse could have been handled more surgically but theexisting regime did not allow that

• The bailout was better of two evils



The fall of 2008

• Lehman’s and AIG triggered the worst phase of the crisisin the fall of 2008

• Global liquidity dried up, financial institutions dependingon the interbank market found themselves withoutfunding

• The extreme risk levels are clearly visible in the VIX



VIX

0

20

40

60

80

2007 2008 2009 2010



Was it a subprime crisis?

• US subprime mortgages around $1.5 trillion (1.5× 1012)

• If 50% default with recovery 50% — $375 billion

• 3% change in stock market perhaps $500 billion

• Something missing — amplifiers



Policy Response



Crisis over?

• Threatened a repeat of the Great Depression butprevented by the authorities

• Various bailouts, in whose absence large parts of theEuropean and the US banking systems would have failed,with catastrophic consequences for the real economy

• Trade was maintained



World trade

1929 1930 1931 1932 1933

40

60

80

100

120

140

2007 2008 2009 2010 2011

Great Depression

Current crisis



Crisis over according to stock markets

2008 2009 2010

50

60

70

80

90

100

SP 500

FT 100

DAX



Responding correctly

• In the beginning, central banks were reluctant to lowerinterest rates and increase liquidity

• Too much focus on moral hazard and inflation targeting

• All has changed, especially with Lehman’s

• Plenty of liquidity

• Extensive cooperation

• Trade preserved

• Bank collapses contained

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Global Financial Systems Chapter 17 The ongoing crisis ... · Buildup Hidden risk Banking changed Crisis 2007–2008 Policy response Global Financial Systems Chapter 17 ... • Keynes